Published On: 2013-09-20

Based on the reformist stance the new Governor has taken, I would expect that he will begin to address the structural issues of our monetary policy, which have a role to play in the macroeconomic order.

One of the matters to be addressed is the high SLR rate in India. At 23% SLR which banks have to necessarily hold, the government is never constrained to find resources for spending. Further, the government does not pay real market linked interest rates on their borrowings. Since SLR is at 23%, and the CASA of the banking system is 28-30%, it is obvious that most of the banks’ low cost resources are going for SLR, and higher cost deposits are lent to theend borrower at 12-13%.

From the bank’s point of view, these are raising charges of lazy banking, since CASA is at 3-5% and G Sec is at 8.0-8.5%. In an ideal system, government may have to borrow at real market determined rates. So as part of the reforms, I would expect the RBI to reduce SLR by say at least 1% this time, give further reduce SLR substantially in tranches going forward.

Secondly, I expect that the RBI will reverse the 200 bps increase in MSF from 8.5% to 10.5% that they announced in August 2013. The rates were increased to prevent borrowing at low cost for arbitrageurs. “Better that investors take positions domestically and provide depth and profits to our economy than taking our markets to foreign shores” the Governor had said in his opening statement, clearly indicating that he acknowledges that the trading is happening in other markets like the NDF market, not just by domestic arbitrageurs- which high short term interest rates were meant to address. Based on this I expect him to reduce the MSF back to 8.5%.

Coming to inflation, August Inflation numbers at 6.1% as compared to 5.79% in July 2013. This is a tricky sort of number. It’s a marginal increase over the last month, and in absolute terms cannot be considered very high if India has to aspire for growth. A good portion of this inflation is primary articles (up 11.7%), food articles (up 18.18%) and vegetables and this sort of inflation cannot be cured by higher interest rates. The manufacturing index rose only 1.9% in August 2013.

The issue though is from the savers’ point of view as the real interest rates have been negative for a long period of time. (This has turned positive only recently, that too marginally, with August CPI was at 6.1% and bank FDs at 8-9%). With negative or low savings rates, there is a tendency for the savers to move their money to property or gold. Even gold too can get into bubble territory, as it is like any other commodity. Coupled with historical returns over the last 10-15 years on these asset classes, it is becoming irresistible for the savers to move their money to these non-financial investment classes. Which is the reason why the savings rates are dipping in India below the 34% we saw a couple of years ago.

Since real interest rates are negative, I see little chance for any reduction in policy rates, particularly Repo Rates, which will at best be left at current rates. In fact, it should not come as a surprise even if the RBI raises repo rates by say 25 bps, and withdraw the recent 200 bps increase in MSF, and reduce SLR simultaneously. This will establish that the RBI means to be tough on inflation, at the same time would like to release funds for productive lending.

In a way, this could even be more effective than Inflation indexed Bonds, as the retail customer will find it much more convenient to park money into fixed deposit of banks as he habitually has, rather than in bonds where he has to worry about mark to market.

Post October 2013, food prices will come down on a good harvest when monsoons retreat, and the real interest rates will turn significantly positive, giving the RBI room to reduce interest rates. Since the Rupee has significantly improved of late, the imported inflation too should come down. They may give even give guidance that they expect inflation to come down in the coming few months based on good monsoons, and guide that as the government introduces newer fiscal measures to reduce fiscal deficit it will give the RBI headroom to reduce rates later.